The scandal surrounding JP Morgan’s losses in its Chief Investment Office is not going away, and for good reason. Its trading book continues to lose money at an astounding rate. The most recent report estimates that the losses have increased by at least 50% more than the bank’s original loss estimates. The total damage is anyone’s guess at this point.
This fiasco is beginning to look a lot like accounting control fraud. The Justice Department and the FBI have begun criminal probes. The SEC is also investigating. So far, the objectives of these investigations are under wraps, but if I were an SEC or DOJ enforcement official I’d be laser-focused on bringing a Sarbanes-Oxley case against Jamie Dimon.
Sarbanes-Oxley emerged out of the Enron frauds. This law requires the CEO to certify that internal controls are operating effectively to give comfort to readers of the financial statements that the disclosures contained in the reporting are reliable. There are civil penalties for filing a false certification and criminal penalties, including jail time, for false filings found to be fraudulent. So far none of the obvious candidates like Dick Fuld at Lehman or Jon Corzine at MF Global have been prosecuted under the law.
Jamie Dimon looks like a very attractive candidate to investigate for SOX violations.
For starters, Dimon’s description of what happened rings SOX alarm bells:
First of all, there was one warning signal — if you look back from today, there were other red flags. That particular red flag — you know, we made a mistake, we got very defensive and people started justifying everything we did. You know, the benefit in life is to say, ‘Maybe you made a mistake, let’s dig deep.’ And the mistake had been brewing for a while, so it wasn’t just any one thing.
– Meet the Press, May 13, 2012
Warning signs and red flags were ignored. And they’ve apparently been ignored since 2007. Once again, echoing what happened at MF Global, risk managers who raised alarms about the riskiness of the positions in 2009 were replaced with more cooperative risk managers:
Several bankers said that risk controls were not sufficiently strengthened by Doug Braunstein, who took over as chief financial officer in 2010, another reason the bolder trades continued.
This indicates the firm was aware of deficiencies in the controls if other executives knew Braunstein had a mandate to improve them. These concerns are probably documented in the meeting minutes of the management committees responsible for risk, financial reporting and SOX compliance. It shouldn’t be difficult for the SEC to review these sources to determine who knew what and when about the state of the internal control environment.
JPM has issued quite a few financial statements since 2007 and 2009. If the controls and riskiness of the trades were as alarming and deficient as the managers indicate, then the reliability of the financial statements for the last 5 years are questionable. For a portfolio of this size and importance it’s inconceivable that the controls and risk issues were not reported up the management chain.
More damning is Dimon’s tacit admission that the controls designed to protect the firm from these sorts of blowups were ineffective, due to lack of intervention. Ignoring internal controls, or red flags as Dimon characterizes them, is a failure in the control environment. The failure to disclose inoperative key controls in the CEO certification is a violation the law.
That’s the big picture case. Recent reporting about the trade itself point to other areas that should be investigated for Sox violations.
When is a Hedge not a Hedge?
It appears that the JPM portfolio ‘hedge’ isn’t a hedge at all, at least according to current accounting standards. As Dina Dublon, CFO of JP Morgan Chase from 1998 to 2004, explained:
Dublon also pointed out that JP Morgan’s $200 billion mistake was not an accounting loss. “There is a difference between accounting and economic valuations,” she said. “You have a mark-to-market hedge against an accrual exposure that is not being marked to market. So you can have a gain or loss on the hedge, but you will not recognize the change in value of the loan portfolio, which is on an accrual accounting basis.
Translating this into non accountant language, JPM had a portfolio of assets which are available for sale. The change in the value of those securities is tracked, but since they aren’t considered to be trading assets, the change in value doesn’t hit the bottom line until they are sold. By contrast, positions held in trading books are “marked to market,” meaning they are revalued as market prices change and the resulting gains or losses are reported on an ongoing basis.
JPM reported that this portfolio contains significant unrealized gains. Indeed, it realized some of those gains to offset the losses on the portfolio ‘hedge’.
To hedge this portfolio JPM bought and sold credit default swaps. This portfolio ‘hedge’ is accounted for on a mark to market basis. This is odd since a true hedge should get the same accounting treatment as the asset it’s hedging. This indicates that the ‘hedge’ failed the hedge effectiveness test required by the accounting rules that would qualify it for hedge accounting treatment. More precisely the correlation between the hedge and the underlying isn’t strong enough to qualify it as a hedge.
Further confirmation that the ‘hedge’ wasn’t technically a hedge comes from Jamie Dimon himself.
In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective an economic hedge than we thought.
As Dublon explained above, “There is a difference between accounting and economic valuations.” Dimon takes care to refer to the ‘economic hedge’, which is a term of art. It has no significance for financial disclosure purposes. It means whatever the user wants it to mean. If Dimon has not been vigilant in using the phrase ‘economic hedge’ in his disclosures and public comments about this portfolio then he’s made some false disclosures.
An “economic hedge’ is not a ‘hedge’ for financial disclosure purposes. ‘Economic hedge’ is a meaningless phrase. The abbreviated term ‘hedge’ when used to describe the trading portfolio embedded in the CIO book is a false characterization of the portfolio. He should not be permitted to describe this as a hedge in any of his comments about this book. At a minimum, he should be called on it every time he utters the phrase.
If It’s Not a Hedge Then What is It?
To recap, JPM owns a portfolio of securities it is ‘economically hedging” with a portfolio of credit default swaps. The purpose of a hedge is to reduce the risk of adverse price moves on the underlying portfolio.
The CDS portfolio consists of CDS purchased and CDS sold.
CDS purchased for the portfolio may have been put on as a hedge against the “available for sale” portfolio. But the CDS sold as a hedge doesn’t seem to make any sense. Selling CDS is equivalent to increasing the exposure to the underlying credits. The CDS sold don’t seem to have a risk mitigating role as part of a hedge, but to date JPM hasn’t provided the information to evaluate the overall portfolio.
It’s possible JPM was funding the CDS purchases by selling longer dated CDS and justifying the inclusion of the CDS sales as funding of the hedging purchases, but that would seem to be pretty expansive definition of a hedge. Perhaps ‘economic hedging’ as JPM defines it includes the funding sources of the combined ‘economic hedge’. That seems ridiculous but the term is open to any interpretation.
Since the combined CDS portfolio is accounted for on a mark to market basis, the position may not have raised any red flags with readers of the financial statements as long as it was in the money. That appears to have been the case for an extended period, as evidenced by the enormous pay packages (over $100 million for the chief trader, the infamous Whale, if reports are to be believed) for the CIO desk. You don’t pay that kind of money to hedgers.
But the position has cratered this year and JPM was forced to disclose the losses on the CDS portfolio. To offset those losses JPM sold off some of its AFS portfolio. We’re still waiting for a precise definition of economic hedge from JPM.
This characterization raises additional alarms, since it appears that JPM effectively viewed the AFS/CDS portfolio combination as a net trading position. Normally, you wouldn’t sell your AFS portfolio (or enjoy the beneficial accounting treatment) unless there was an extraordinary exogenous event that caused you to liquidate the portfolio. Trading losses on a portfolio jointly managed as part of the AFS portfolio wouldn’t qualify.
This raises the question of whether JPM has correctly classified the available for sale assets since they acquired them. That’s a serious issue. If JPM misclassified a $200B position for years, it should be investigated for a host of regulatory violations and fraud.
For all intents and purposes the hedge portfolio is a separate trading book, and the financial reporting reflects that fact. There should be no way JPM should be able to spin this as a hedge of anything and deny the proprietary trading characterization the accounting treatment signifies.
What’s up With the Value at Risk?
Another area the SEC needs to investigate is the curious restatement of the VaR, which is a measure of risk used in disclosures to investors and regulatory reviews.
As discussed above, the risk exposure of the marked to market positions (the hedge porfolio) must be disclosed in the financial statements. JPM recently replaced the VaR model for this portfolio. It appears that the new model significantly understated the risk exposure and the bank has hastily reverted to an “older” model. One benefit of a reduced risk exposure is a reduction in capital held against the portfolio. Under the new model JPM would only have been required to hold half as much capital on the portfolio, than it did under the original model
It is extremely unusual that a risk model for such a critical portfolio isn’t exhaustively vetted both internally and by the regulators before it was permitted to be installed. There was clearly a breakdown in the controls around that model replacement. This breakdown resulted in a significant and material underreporting of risk in the initial 1Q 2012 SEC reporting. The restatement validates that a material breakdown in internal controls existed before the model was implemented.
It also raises other questions. Blaming models for management failures has become a fairly standard first response during the financial crisis. When HSBC took their first big hit on their securitization business in the 2007 (for fiscal year 2006), and shut down their US securitization business, they attributed the losses to the discovery that their credit risk models were flawed. I have no doubt this was true, but the discovery of the flawed model also coincided with the beginning of the collapse of the RMBS market.
The revelation by JPM in the days immediately following the reports of the Whale’s trade, that the new VAR model seriously underestimated the riskiness of the portfolio, is more significant to a SOX investigation around adequacy of controls than an investigation into the adequacy of the model itself for risk management purposes.
This sort of “whoops our models understated risk” is a convenient way to shift blame off management to “model error” for a decision to take on additional risk. Given that easy profits in banking are vanishing, which are we to believe: that JPM, heretofore seen as a leader in the CDS marker, suddenly became grossly incompetent? Or did they decide to take on more risk and implement models that would mask from regulators and the public the scale of the wagers they were taking?
It also raises concerns about other models use for these portfolios. Many of the underlying assets in the portfolio are illiquid and complex securities. The models used for pricing these instruments and reporting valuations deserve additional scrutiny at this point as well.
It doesn’t look like JP Morgan made a bunch of egregious mistakes. It looks like they broke the law, at least the Sarbanes-Oxley law.
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